Flipping for family limited partnerships

The family limited partnership (FLP) has proven to be a valuable tool for business and estate planning. What other tool can ease the tax bite often associated with the transfer of an injection molding operation or its income to family members, while keeping the owner’s tax bills to a minimum?Transferring assets to family members can be an invaluable tax-reducing and planning tool. Income can be shifted to an individual in a lower tax bracket than the donor. What’s more, the transfer of an interest in a partnership can represent a future increase in value, the legitimate deferral of taxable gain. Naturally, the advice of a professional should be sought, if only to avoid doing battle with the IRS.

What is an FLP?

A family limited partnership is a limited partnership consisting of only family members. A limited partnership has both general partners (the ones who actually run the partnership) and limited partners (noninvolved investors). General partners have unlimited personal liability for partnership obligations, while limited partners have no liability beyond their capital contributions.

Typically, a partnership is formed by the older generation, usually the parents, who contribute assets to the partnership in return for general and limited partnership units. The parents can then embark on a plan of giving unlimited partnership units to their children while retaining the general units that actually control the partnership.

Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, marketable securities, and of course, the family injection molding business. Thus, the parents retain control of the business; they draw wages from it while sharing the profits with family members who are taxed on those profits at a lower tax rate than the parents/owners.

The partnership agreement usually governs how partnership income is divided among the partners. Normally the general and limited partners share income based on their respective percentage of interest in the partnership. Although income tax liability passes through to each partner automatically, actual cash does not have to be distributed to the partners until the general partners decide to make a distribution.

In this manner, the general partners retain control over the assets in the FLP while the limited partners are granted limited rights.

The Value of FLP Discounts

As part of establishing a partnership, property and assets are transferred into the partnership. Frequently this involves a transfer tax at the state level. Because of the lack of an established market for the sale of limited partnership interests, they are often valued at a discount for transfer tax purposes, as well as federal valuation purposes. Valuation discounts for limited partnership interests, i.e., reductions from the net asset value of the partnership, can range from 15% to more than 50%. The tax benefit of the discounted value of the partnership interests, coupled with significant nontax benefits such as liability protection and centralized management, have contributed to the historic popularity of the limited partnership.

Let’s look at how this can affect a molder or moldmaker. John Doe owns an injection molding company that has been in the family for 50 years. The family business consists of land, buildings, and machinery with a total value of $5 million.

John is focused on keeping the business in the family. With the assistance of a professional, John organizes a limited partnership to hold the physical assets of the family business. John and his son Ralph are the two general partners, together owning a 1% interest equally.

John contributes the family business to the partnership for a 99% limited partnership interest, while Ralph contributes cash or other assets for his interest.

Assuming that a 40% discount can be sustained when valuing the partnership interest, the value of John Doe’s estate is reduced by $2 million. That can mean estate tax savings of as much as $1 million, assuming that the estate tax remains a factor on the federal level.

Despite the repeal of the estate tax, temporary as it may be, the benefit of reduced asset value through significant valuation discounts remains for gift tax purposes. Subsequently, the FLP has not escaped IRS scrutiny.Be aware that the IRS often challenges, with mixed success, FLPs in the courts. But that should not deter any manufacturer with an honest desire to transfer his business, or its income, to family members. After all, none of the IRS’s challenges has been successful in eliminating FLPs, nor has it severely affected any injection molding business owner that closely adhered to the rules.

Obviously, using an FLP requires both careful analysis and strict compliance with IRS regulations, not to mention professional assistance. FLPs, however, are well worth the cost of investigating, establishing, and maintaining from a variety of standpoints—not the least of which is taxes.

Author Mark E. Battersby of Ardmore, PA is a tax and financial adviser, freelance writer, author, and lecturer. Contact him at [email protected] or (610) 789-2480.